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BOSTON/SEATTLE (Reuters) – Yahoo Inc’s second-biggest investor urged Microsoft Corp to raise its $42 billion bid for the Web pioneer and warned Yahoo it has few options left, raising the pressure on them to seal a deal.

In a quarterly letter to investors released on Tuesday, Bill Miller, the star stock-picker at U.S. asset manager Legg Mason Inc.,estimated fair value for Yahoo to be near $40 per share, versus Microsoft’s original offer of $31 per

share.

Microsoft “will need to enhance its offer if it wants to complete a deal,” Miller wrote in a February 10 letter, one day before Yahoo formally rejected Microsoft’s plan for the company.

“It will be hard for (Yahoo) to come up with alternatives that deliver more value than (Microsoft) will ultimately be willing to pay,”

Miller wrote. “We think this deal is a strategic imperative for (Microsoft) and that (Yahoo) is in a tough spot if it wishes to remain independent.”

Miller’s comments came as major institutional Yahoo shareholders have been working behind the scenes to get the parties to strike a deal, analysts say. Around 53 of the top 100 big funds in Yahoo hold shares in both companies, according to the most recent shareholder data available from September.

Institutional shareholders hold about 75 percent of Yahoo’s stock, according to Reuters data, versus 10 percent for company insiders, including co-founders David Filo and Jerry Yang.

Legg Mason Capital Management, the unit of Legg Mason run by Miller, owns more than 80 million Yahoo shares, or 6 percent of the company, trailing only Capital Research & Management’s 11 percent holding.

Yahoo on Monday turned down Microsoft’s bid, now valued at $41.7 billion, saying it did not properly assess the value of Yahoo’s vast audience, online advertising investments, cash generation and growth prospects of its overseas holdings.

Microsoft responded the same day by saying its offer was “full and fair,” but stopped short of saying it would not raise its price.

Redmond, Washington-based Microsoft also said it reserved the right “to pursue all necessary steps” without specifying if it plans to take its bid straight to Yahoo shareholders.

COUNTER OFFER

Analysts expect Microsoft to raise its bid to at least $35 a share, but some believe it could be persuaded to go as high as $40.

RBC Capital analyst Jordan Rohan said major funds are likely to grow impatient with Yahoo to get a deal done if Microsoft raises its bid a few dollars to the mid-$30s-a-share level and sweetens the cash portion of its existing offer.

“The more vocal funds are almost threatening Yahoo that they better take the next offer,” Rohan said.

Yahoo shares are now trading at a 2 percent premium to Microsoft’s cash-and-stock deal, indicating investors expect Microsoft to raise its bid.

Legg Mason’s Miller noted Yahoo shares had been trading at a four-year low prior to Microsoft’s offer and the stock was trading above Microsoft’s bid price for all of 2004.

Yahoo continues to lose Web search market share to Google Inc. Last month, it disappointed Wall Street with its 2008 revenue outlook as it promised to cut jobs and invest more in online advertising work.

According to employees at the Sunnyvale, California-based company, Yahoo began carrying out those lay-offs of up to 1,000 employees on Tuesday. A Yahoo spokeswoman declined to comment.

Several Wall Street analysts said the chances of alternate bidders for Yahoo emerging have grown remote because any deal would

have to be structured in such a way that it can compete with a roughly 60 percent premium implied by Microsoft’s bid.

Citigroup issued a research note on Tuesday saying the likelihood that Microsoft will offer a higher bid to clinch a deal with Yahoo

is rising. It now puts the probability that this will occur at 55 percent.

The second-most-probable scenario with a 30 percent chance, according to Citigroup, is that Yahoo remains independent and outsources its search to Google.

Speculation has swirled in recent days that Yahoo is considering potential deals that could involve pairing off with either Time

Warner Inc’s AOL or News Corp’s MySpace, if their media companies were prepared to spin these businesses off.